The Case for Gold and Silver

My last two posts covered the investment outlooks for stocks and bonds. In short, now is not a good time to invest in either. Stocks have only been this expensive three times since 1880: 1929, 1999, and 2007, after which stocks fell 45% or more. I believe another stock crash will soon occur. It may not be as bad as a 45% drop, but it will be bad. Bonds, like stocks, are also crazy expensive. They, in fact, have never been as expensive as they are now. In both of these investments, it is possible that we could see one last bull run in the next year before things go south. But for both stocks and bonds, the risk far outweighs the potential returns at this point.

So where can you invest to actually make money? There is significant value in precious metals: gold and especially silver. Before you start thinking I’m a doomsday prophet, allow me to explain the financial reasoning for buying gold and silver. In other words, I’m not also going to recommend that you stockpile baked beans and ammo in your basement (although that might not be a bad idea either!). I believe gold and silver can make me money, and that’s why I invest in them.

There are many factors that lead me to invest in gold and silver, and the first one is very simple. You’ve heard the mantra a thousand times I’m sure: buy low and sell high. Gold and silver have been falling for the last five years, and I believe they have bottomed out. Check out the chart of silver for the last 20 years:

Link: https://www.bullionvault.com/gold-price-chart.do

As you can see, silver reached an all time high of $46.47 per ounce on March 26, 2011. In November of 2015, silver reached an astounding low of $13.88 per ounce! That’s about a 70% drop! Since then, silver has reversed its decline and has reached $17.50 per ounce. It appears $13.88 was the low for silver, and it’s now on its way back up. If you were to invest now and silver returns to its all time high, you would realize an amazing 271% return! You would almost triple your money.

So why am I focusing on silver over gold? While both would be a good investment, I believe there is much more potential to make big money in silver over gold. Let’s talk about the gold to silver ratio. Because there is 26 times more silver on Earth than gold, the price of silver should be 26 times lower than the price of silver. It’s the principle of supply and demand. While demand may be higher for gold than for silver, the price ratio should be somewhere around that level. During the Roman Empire, you would have to turn in 12 ounces of silver for 1 ounce of gold. When the US used gold and silver as currency, you would have to turn in 15 ounces of silver for 1 ounce of gold. You may be asking, “So what?” Well, at current prices, you would have to exchange 74 ounces of silver to get 1 ounce of gold! In other words, silver would have to rise to exactly $50 per ounce to achieve the 26 to 1 exchange rate. Of course, this ratio could also be achieved by a substantial fall in gold prices, but I don’t see that happening after having already experienced five years of falling. Plus there are other factors that lead me to believe that both gold and silver will be rising.

So what makes gold and silver rise? It’s actually pretty simple if you think about it. As the government continues to print money, each dollar becomes less valuable. Think of it this way. Say there are a million dollars in circulation. You have 500,000 of them and your neighbor has 500,000. So you and your neighbor each have 50% of the money supply. The government is greedy, however, and they want 1,000,000 dollars for themselves too. So they simply print off 1,000,00 more dollars. Now, there are 2,000,000 dollars in circulation, but you still have 500,000. Whereas you held 50% of the the money supply before, you now only hold 25% of the money supply. You became a lot less wealthy comparatively. How do you prevent this from happening? Simply don’t hold dollars. Instead, trade them in for something real that the government can’t print: gold or silver. As dollars become more and more worthless, your gold and silver look comparatively better, and people will be willing to pay more and more for them. Below is a chart that compares world government spending to the price of gold. Precious metals are undervalued.

Because governments will always print money, gold and silver will always rise in the long run. Therefore, I believe both gold and silver will rise. However, silver will need to rise exponentially more to achieve the gold to silver ratio of 26:1. I am not a “gold bug” who will live and die by my gold and silver. If stocks were to fall 50%, I would sell the majority of my precious metals and invest in stocks. It’s all about knowing where you can earn the most money going forward, and right now, I expect gold and especially silver to provide by far the best returns.

Bonds: Investment Outlook, June 2016

As mentioned in yesterday’s investment outlook, bonds are perhaps more expensive than stocks right now. Stocks have only been as expensive as they are right now three times in recordable US history. Bonds, on the other hand, have never been as expensive as they are now!

Sometimes it can be confusing to think of bonds as being overvalued or undervalued because bonds are supposed to be ultra-stable, only-go-up-in-value investments, right? Actually, no. Bonds have been on the longest bull run of any investment – for 33 years now. Therefore, most of us either weren’t around or can’t remember when bonds lost money from year to year.

What determines the price of bonds? For the high credit quality bonds that I recommend, interest rates cause 95% of price fluctuations.

Let’s look at an example: the year is 1980, and you happily purchase a ten year treasury bond yielding 10% per year. Two years later, you’re not so happy. In 1982, the going yield for treasuries becomes 15% per year, and you are locked into receiving 10% on your treasury bond. Because your bond pays less in comparison to shiny, new bonds, the price of your bond plummets. Whereas you probably bought your bond at par value ($1,000), you could now only sell it for around $700.

Sure, you could hold onto the bond until it matures in eight more years. That would mean that you would get back your full $1,000. But in the mean time, it can be very scary to see a United States Treasury Bond, supposedly the safest investment in the world, lose 30% in value. Not only that, the inflation rate in the US reached 15% around 1982. This means that after inflation, you were gaining a 10% yield on your treasury bond but losing 15% to inflation. Over two years, that’s a total of a 40% loss. You lost 30% on the value of your bond plus two years of -5% real returns due to inflation.

Real return = return you see – inflation.

Check out this historical yield chart. It shows you how much ten year treasuries yielded historically.

(Source: http://www.multpl.com/10-year-treasury-rate)

So we learned that the price of bonds moves opposite of interest rates and that inflation can result in negative real returns. These are two major problems for today’s market.

First, as you can see in the chart, today’s ten year treasuries yield only 1.6% – they have never yielded this little. If the price of bonds moves opposite of interest rates, and interest rates can only fall 1.6% before they’re 0%, there isn’t much room left for prices to rise.

Second, inflation could come roaring back at any time. Because of the 2008 crash, the Federal Reserve TRIPLED the number of dollars in circulation. Historically, inflation follows the increase in the amount of money in circulation, although it may take a while to surface. We haven’t seen it yet. Inflation has been near zero. It’s out there, but it hasn’t surfaced. If you buy a treasury bond yielding 1.6% and we have a minor inflation scare of 5% inflation per year, you’re losing 3.4% per year. And that’s assuming a minor scare and not something much larger.

Could yields fall further and rise in price? Absolutely. Ten year government bonds of European countries and Japan have fallen into negative interest rates! That means that you can hand over your money to the government for ten years, and you have to pay the government interest, not the other way around. It sounds crazy, and it is. It’s absolutely ridiculous, and it has never happened before. I don’t think it will end well.

Going forward, there are three possible scenarios for bonds:

Scenario 1: On average, the economy enters a recession every six years. It has been eight years since our last recession. If the economy enters a recession, US treasury yields will fall even further, perhaps reaching negative rates just like European bonds. This would result in your bonds making money.

Scenario 2: We could enter another period of “stagflation” which stands for stagnant economy, high inflation. Stagflation describes the period in the late 1970’s and early 1980’s we talked about above. This would certainly not be good for your bonds. Inflation and interest rates would skyrocket, and your bonds would lose a lot of value.

Scenario 3: The economy does great, and interest rates rise, causing the value of your bonds to fall.

I would give scenario one a 45% chance of happening, scenario two a 45% chance of happening, and scenario three a 10% chance of happening.

Bonds are certainly not a sure bet. If you do buy them, stick to high quality, short to intermediate term (1 to 5 year) municipal or treasury bonds. In particular, TIPS bonds offer the best value right now. TIPS stands for Treasury Inflation Protected Securities. They offer basically no cash flow, but their price rises along with inflation! So if inflation is 5%, you will earn 5%. Not amazing, but at least you wouldn’t have lost money.